Your input on options for 2021 income

[Scuba]

That 16 years is consistent with the right column of the analysis that I provided at post #32, which was 17 years... the negative cash flow of paying the tax is offset each year by avoiding tax on what was effectively transferred from the taxable account to the Roth. The disadvantage grow a little each year until RMDs begin at which point it is recovered over about 10 years.

That's comforting to at least confirm that the timeline Fidelity is suggesting seems reasonable. I went back into i-Orp and ran the model, and it's now suggesting that Roth conversions up to the 24% bracket will give us a slight advantage vs no Roth conversions. It won't even run the numbers for us at any lower brackets - I get a model error message. While it shows a small advantage for partial conversions, it isn't a compelling, life-changing advantage. Interestingly, a summary of i-Orp's research says that on average, Roth conversions yield about a 1% benefit vs not converting. I'm surprised it is so small.

Some missing things in the model analysis:
- As far as I can see, it doesn't allow one to compare the advantages of Roth conversions vs generating LTCG income in a taxable account.
- I've assumed we both live a similar life span so I suppose results would be different if I assumed one of us meets with an early demise. OTOH, since we already have plenty to fund our lifestyle for the rest of our lives based on the assumptions, if only one person were left, there may be a higher tax rate, but there would be lower expenses too.

 

[Scuba]

Because the taxes are a fraction of the cash you've made available for spending. I pay a little out of my taxable account to get a lot in my Roth. One of the benefits of doing Roth conversions is that you make that money available for spending. If I have a major expense, over $100K say, I can take money out of the Roth tax-free. If I take it out of the tIRA I take a major tax hit because I pushed my taxable income up a couple of brackets. So I have better cash flow after conversions.

So far nobody else sees it my way, so I won't prolong the discussion. Probably I'm bending the definition of cash flow too much.

At the very least this should be seen as a neutral transaction in my net worth. I'm removing a liability by the amount of asset I reduced by paying the taxes.

I see what you're getting at now. We use our taxable account for those unplanned major expenditures, not our tIRA's. So in our case, a Roth conversion would significantly reduce our liquidity - if we converted up to the 24% Federal bracket, and we also paid say 12% in state taxes (in CA), then we reduce liquid assets by 36% of the Roth conversion amount.

 

[tb001]

That's comforting to at least confirm that the timeline Fidelity is suggesting seems reasonable. I went back into i-Orp and ran the model, and it's now suggesting that Roth conversions up to the 24% bracket will give us a slight advantage vs no Roth conversions. It won't even run the numbers for us at any lower brackets - I get a model error message. While it shows a small advantage for partial conversions, it isn't a compelling, life-changing advantage. Interestingly, a summary of i-Orp's research says that on average, Roth conversions yield about a 1% benefit vs not converting. I'm surprised it is so small.

Some missing things in the model analysis:
- As far as I can see, it doesn't allow one to compare the advantages of Roth conversions vs generating LTCG income in a taxable account.
- I've assumed we both live a similar life span so I suppose results would be different if I assumed one of us meets with an early demise. OTOH, since we already have plenty to fund our lifestyle for the rest of our lives based on the assumptions, if only one person were left, there may be a higher tax rate, but there would be lower expenses too.

I had the same issue with iORP. When I model doing roth conversions it ends up decreasing our overall tax burden by about 100K, assuming we live to 95, but front loads our spend significantly so we are more subject to SORR.

I believe you're not far from us. If you have a CPA who has been helpful with this, we'd love a referral if you feel comfortable PM'ing me. I've been 100% DIY and really need someone to help me think through it/double check my numbers. We spoke with a vanguard rep about their advisory services and the rep, while very good, told us that given our level of planning he didn't think we would see value from their advisory fee. Nice to have the transparency, but we still need a second set of eyes!

 

[Out-to-Lunch]

I see what you're getting at now. We use our taxable account for those unplanned major expenditures, not our tIRA's. So in our case, a Roth conversion would significantly reduce our liquidity - if we converted up to the 24% Federal bracket, and we also paid say 12% in state taxes (in CA), then we reduce liquid assets by 36% of the Roth conversion amount. [emphasis added]

I suppose it depends on what you are counting as liquid assets? By one definition, once you do the conversion, the full amount of the converted amount becomes liquid.

In my view, doing the conversion has not affected your ability to spend money (from the sum total of your assets).

 

[CardsFan]

- Do a Roth conversion. We don’t have any Roth IRA’s now. Traditional IRA’s make up about 1/3 of our financial assets. The rest are taxable brokerage accounts and a couple of employer-provided deferred compensation and annuity accounts. We have looked at Roth conversions before using i-Orp and other modeling tools and it has never been particularly advantageous for us. We have no children or heirs we want to leave big bucks to.

I am not quite sure why you want to increase your taxable income.

Based on the bold above, and the fact that you have 2/3's of you assets pre-tax, if it were me (and it is not) I would not do anything to increase income and taxes.

I am making an assumption that your assets are fairly large.

What I would do is live off the after tax income until RMD's hit. I would then give away a significant amount of the RMD to charity. This comes off the top, and does not create a tax increase. I think the limit is around $100k now, others will correct me if I am wrong.

Am I missing something?

 

[pb4uski]

I see what you're getting at now. We use our taxable account for those unplanned major expenditures, not our tIRA's. So in our case, a Roth conversion would significantly reduce our liquidity - if we converted up to the 24% Federal bracket, and we also paid say 12% in state taxes (in CA), then we reduce liquid assets by 36% of the Roth conversion amount.

Unless you are sure that you would incur much higher taxes once SS and RMDs start, I don't think I would be doing a lot of Roth conversions at a combined federal/state tax of 36%.

 

[Scuba]

I just want to add a consideration for the Roth conversions in that a surviving spouse will be in a much higher tax bracket.

Thank you. This is a very good point that I'll need to consider further.

 

[Scuba]

Unless you are sure that you would incur much higher taxes once SS and RMDs start, I don't think I would be doing a lot of Roth conversions at a combined federal/state tax of 36%.

That is why we haven't done it to date. However, I hadn't really thought about the surviving spouse tax rate issue. Do you think that's a good reason to do at least some Roth conversion? I'm not sure we're ever going to be in a lower bracket than we are now, except for "unusual" and unpredictable years where we may have capital losses on certain investments.

 

[RunningBum]

That is why we haven't done it to date. However, I hadn't really thought about the surviving spouse tax rate issue. Do you think that's a good reason to do at least some Roth conversion? I'm not sure we're ever going to be in a lower bracket than we are now, except for "unusual" and unpredictable years where we may have capital losses on certain investments.

To me it's still the same basic tax arbitrage play no matter what your tax rate is, especially if you can pay taxes out of your taxable account. Along with the financial advantage, you have more flexibility with money in a Roth than in a tIRA.

However, that higher rate opens up more possibilities that taxes won't be lower later.
- Might you move out of California at some point, and stop paying CA income tax?
- You said no heirs, but for anyone else in a similar situation with heirs in a lower tax rate following this it might be better for the heirs to inherit the tax deferred money. Keep in mind that all must be withdrawn within 10 years, but with lots of heirs the pie is cut in smaller pieces.
- As someone else posted earlier, if you charitable giving in mind, taking QCDs out of tax deferred and bequeathing tax deferred money is more efficient.

It's also unlikely that this is a big gainer, especially %wise in your finances either way. For some that means don't bother convert; for me it would mean doing a quick estimate of conversion to the next tax bracket to rid myself of the deferred tax liability and not deal with RMDs, if I can.

 

[Scuba]

To me it's still the same basic tax arbitrage play no matter what your tax rate is, especially if you can pay taxes out of your taxable account. Along with the financial advantage, you have more flexibility with money in a Roth than in a tIRA.

However, that higher rate opens up more possibilities that taxes won't be lower later.
- Might you move out of California at some point, and stop paying CA income tax?
- You said no heirs, but for anyone else in a similar situation with heirs in a lower tax rate following this it might be better for the heirs to inherit the tax deferred money. Keep in mind that all must be withdrawn within 10 years, but with lots of heirs the pie is cut in smaller pieces.
- As someone else posted earlier, if you charitable giving in mind, taking QCDs out of tax deferred and bequeathing tax deferred money is more efficient.

It's also unlikely that this is a big gainer, especially %wise in your finances either way. For some that means don't bother convert; for me it would mean doing a quick estimate of conversion to the next tax bracket to rid myself of the deferred tax liability and not deal with RMDs, if I can.

Good point re possibly moving out of CA someday. No plans to do that, but it could certainly happen as we've been known to move rather impulsively before.

The other thing I realized today upon discussing again with our CPA is that based on current tax law, the surviving spouse will get a stepped up basis on our real and financial investments. Assuming this doesn't change for estates such as ours, that would minimize the need for a Roth because the surviving spouse's RMD's from the tIRA's won't be huge, and the rest of the living expenses could be sourced from SS, pension income, and the taxable portfolio with a new higher basis and therefore low capital gains taxes, if any.

I think with everything I've learned up to this point, I'm leaning towards recognizing some LTCG's this year, which can also be used to reallocate assets and replenish our short-term operating funds, and leaving it at that. We can recognize a lot of gains for a 15% federal tax rate.

Thanks to all posters on this thread. Your input has been enlightening and helpful!

 

[bevette]

What about splitting the difference and doing a smaller amount of both? Harvest a bit of LTCGs, and do a smaller Roth conversion.

 

[pb4uski]

Great idea... only 56 posts too late.

[I suggested the same thing in post #5 of this thread]

 

[Scuba]

I suppose it depends on what you are counting as liquid assets? By one definition, once you do the conversion, the full amount of the converted amount becomes liquid.

In my view, doing the conversion has not affected your ability to spend money (from the sum total of your assets).

My thinking is that to really benefit from the up-front tax payment required for a Roth conversion, one has to leave the money in for 10 plus years. We would pay the taxes from our taxable brokerage account we are currently using to fund our lifestyle. Both in terms of liquid assets and total assets, we would see an immediate decrease due to taxes we would not otherwise be paying at this time. The tax free growth of the Roth would eventually make up for the taxes, but it would likely take quite a long time and in the meantime, we’d have lower total assets, as well as less money in a taxable brokerage account and more in an account we shouldn’t touch for a decade or more.

 

[Scuba]

Great idea... only 56 posts too late.

[I suggested the same thing in post #5 of this thread]

But then once I mentioned our tax bracket, it seemed that you backed off the Roth conversion idea for us.

 

[pb4uski]

What is your tax bracket before any Roth conversions? If it is 22% or higher before any Roth conversions then itis hard for me to see the value... but if it is below 22% without Roth conversions I would consider filling up to 12% with Roth conversions and then do capital gains on top of that.

 

[Scuba]

I am not quite sure why you want to increase your taxable income.



Based on the bold above, and the fact that you have 2/3's of you assets pre-tax, if it were me (and it is not) I would not do anything to increase income and taxes.



I am making an assumption that your assets are fairly large.



What I would do is live off the after tax income until RMD's hit. I would then give away a significant amount of the RMD to charity. This comes off the top, and does not create a tax increase. I think the limit is around $100k now, others will correct me if I am wrong.



Am I missing something?

I started thinking about a Roth conversion because so many here advocate it and we don’t have any Roth assets yet. Many here seem to convert up to the top of their tax bracket which means they prepay some taxes but smooth taxes out over their lifetimes rather than be in higher brackets later with RMD’s, SS, and pensions. Conceptually this makes sense to me. Our CPA believes that smoothing out our taxes over time is also a good strategy for us, but suggested that generating LTCG’s would be more advantageous for us than doing a Roth conversion.

 

[pb4uski]

When I had a lot of LTCG I favored Roth conversions over LTCG... my thinking was that assuming that stepup in basis doesn't go away that stepup would make all those LTCG go away tax free so why use tax brackets for LTCG.

 

[Out-to-Lunch]

My thinking is that to really benefit from the up-front tax payment required for a Roth conversion, one has to leave the money in for 10 plus years. We would pay the taxes from our taxable brokerage account we are currently using to fund our lifestyle. Both in terms of liquid assets and total assets, we would see an immediate decrease due to taxes we would not otherwise be paying at this time. The tax free growth of the Roth would eventually make up for the taxes, but it would likely take quite a long time and in the meantime, we’d have lower total assets, as well as less money in a taxable brokerage account and more in an account we shouldn’t touch for a decade or more. [emphasis added]

You seem to be valuing a dollar in a tax-deferred account the same as a dollar in a Roth. They do not have the same value to you.

 

[Scuba]

You seem to be valuing a dollar in a tax-deferred account the same as a dollar in a Roth. They do not have the same value to you.

No, I’m valuing the dollars in a taxable brokerage account similarly to a Roth. Tax deferred is worth less compared to a Roth or a taxable brokerage.

 

[Scuba]

When I had a lot of LTCG I favored Roth conversions over LTCG... my thinking was that assuming that stepup in basis doesn't go away that stepup would make all those LTCG go away tax free so why use tax brackets for LTCG.

You commented that if you were in a 36% tax bracket, you wouldn’t do Roth conversions. Still feel that way? We can take six figures of LTCG’s at 15%.

 

[pb4uski]

You commented that if you were in a 36% tax bracket, you wouldn’t do Roth conversions. Still feel that way? We can take six figures of LTCG’s at 15%.

Well, you need to clarify or remind me in case I missed it... is the 36% if you do no Roth conversions? IOW, the tax cost of any Roth conversions 36% or more? And what is the estimated tax cost on your RMD (difference in tax with and without RMD divided by RMD) once SS and RMDs start... 36% or 38% or some other number?

Also, will your heirs be charities or individuals and if the individuals, what is their tax rate (I presume less than 36%).

If your tax cost on Roth conversions is 36% and your tax cost of RMDs once you are collecting SS and subject to RMDs is even 38%, I wouldn't get very excited about Roth conversions for a 2% difference.

Now on the other hand, if there is a big difference between the tax cost of Roth conversions today vs what you will pay at RMD time then I think Roth conversions make sense. In our case, the first $100 is 0% and then more at 10% and 12% for a net of about 11% of the conversion....and I'm pretty sure that we'll be paying ~17% (a combination of 12% and 22% assuming that rates do not revert but more if rates do revert or increase)... so for us the 6% or better difference make it worthwhile.

 

[Montecfo]

Now on the other hand, if there is a big difference between the tax cost of Roth conversions today vs what you will pay at RMD time then I think Roth conversions make sense.

This I think is the bottom line. It is an investment decision- investing in prepaid taxes. As a value investor, I like a margin of safety. A large tax rate differential provides that.

 

[Out-to-Lunch]

No, I’m valuing the dollars in a taxable brokerage account similarly to a Roth. Tax deferred is worth less compared to a Roth or a taxable brokerage.

Well, I am not following your math then, but that is okay. I don't need to know. I was just trying to help the discussion.

 

[Scuba]

When I had a lot of LTCG I favored Roth conversions over LTCG... my thinking was that assuming that stepup in basis doesn't go away that stepup would make all those LTCG go away tax free so why use tax brackets for LTCG.

I can see this logic for the LTCG still left for the surviving spouse, but we are using our taxable portfolio to fund our lifestyle now. Because the market has performed so well, virtually every equity position in it has a sizable LTCG. So I thought it could make sense to recognize some LTCG's so that as we sell positions over the next 5+ years to rebalance and fund our lifestyle, we could do so without paying what may be a higher LTCG rate then.

I will ask our CPA about how much of a Roth conversion we could do and stay in the 12% bracket. I am not sure if he's looked at the combination of Roth conversion up to 12% and then LTCG's. Thanks for the idea.

 

[pb4uski]

Assuming that you are MFJ over 65 and had no other ordinary income, you could have as much as $107,450 of Roth conversions and pay $9,328 in tax (8.68%).... then any preferenced income (qualified dividends and LTCG) on top of the $107,450 of ordinary income would be taxed at 15%.

So your savings would be what you would pay on that amount at RMD time vs the 8.68%... so if you expect RMDs to be taxed at 22% then you would save $14,312 [$107,450 * (22% -8.68%)].

You can use https://www.irscalculators.com/tax-calculator to test different scenarios.